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Friday, October 22, 2010

History of Economic Thought: The Chicken Model

A chicken model is constructed in the following manner. Assume that consumers like chickens, and also that the private sector cannot produce chickens, but the government can. Therefore, it would be efficient for the government to produce chickens. Randy Wright tells me (confirmed by Richard Rogerson) that this parable originates with Ed Prescott.

The trick in any serious policy analysis is to write down a coherent economic model with a role for the government that is not a chicken model. We have all seen chicken models from time to time. My favorite is IS/LM, where the "chicken" is price flexibility and/or wage flexibility.

30 comments:

Usually I follow what you're trying to say or do. This time I'm lost. Are you saying there is no room for government to produce goods that are not produced otherwise (I would disagree)? Are you saying funky IS-LM models are worthless (agree)? They're good (meh)? You like chicken (OK)?Sorry, lost today.

And what if government really is more efficient at producing chickens (say economies of scale are enormous, so you either have the government do it or you have a private monopoly, and suppose this private monopoly is too hard and costly to monitor and regulate well)?

You don't think in this case it would be efficient for the government to provide chickens?

Anti-chicken models are very useful. Consumers like chickens, private sector produces chickens. Government arrives and starts interfering with the production of chickens. Here are two important examples from recent macro history: 1. Government established regulatory subsidies for AAA-rated junk. 2. Everybody had stable inflation expectations, but in 2008 erratic monetary policy has sharply increased volatility of inflation expectations and dispersion of inflation expectations.

How do we know that the inefficiencies raised by the provision of government goods are smaller than the inefficiencies caused by a private monopoly.

The CEO of the government agency in charged of delivering chickens will likely be a political appointtee that will receive a below market wage. That is not a good start. The employees of that agency are less likely to be selected based on their skills and to be promoted or demoted based on their performance compared to the case of private monopoly. And I can go on...

I could very well be that a private monopoly is a bad alternative. But what I'm saying is that the public provision of goods are contaminated by many inefficiencies too.

As a thought experiment, this forces us to think about what we can really hope for from government. Governments clearly cannot produce miracles that are beyond the power of private agents to produce.

The key issue here, I think, is nature of the objectives of the government and of private agents. Private agents produce only what is in their own self interest to produce, and there are many situations where outcomes driven by purely private interests are not very satisfactory: externalities, public goods, monopoly power, etc... Unfortunately, Adam Smith's invisible hand doesn't solve every problem. (I think even Ed Prescott would agree with that!)

The legitimacy of a role for government, then, rests on it having objectives that transcend the purely private objectives and, thus, having the incentive to solve the problems listed above (externalities, etc).

Unfortunately, of course, private interests always have an incentive to co-opt governments, to have them conform more with their own private objectives. If they fail in that endeavour, they may also have an incentive to discredit government legitimacy with cornball chicken fables.

I am afraid I am sicked of those old schools. Why we keep resorting the role of govt to externality or increasing return to scale?

In the end, a gov't is not god; it's just an organization of folks. Why some folks can't produce chicken but another flock can under a fancy name "government"?

Folks can handle externality problem themselves, maybe by bargaining amongst themselves. Well I can hear some rumblings like transaction cost is high or coordination failure. Please tell me how a folk called gov't can overcome these friction and why another folk can't just replicate the trick of gov't.

Why still treat gov't as alien and exogenously given?

PS: I think the post reflects somethings deeper come up in Steve's mind? Maybe we can some funny anecdote for this weekend....

If people really do like chickens, and if government really is more efficient at producing chickens, then government should produce chickens. It's not a fancy model; it doesn't go back to how atoms (or quantums) interact, and that step by step leads up to government producing chickens, but it's very useful and 100% sound logic, as long as it really is true that government is more efficient at producing chickens, there's no unaccounted for significant side effects.

And with regard to why can't the free market just duplicate anything the government can do, as one anonymous said, briefly, as just one example, the government can decide to not massively pollute, and the voters can hold them to it. A private company has an incentive to pollute; it increases profits, so they won't want to not pollute. So you at least need government regulation -- if it's possible to keep an eye on them well. The government can end a free rider problem with force -- they have police and military, and the private sector doesn't, or at least in this country, forces not nearly as powerful as the governments.

A giant global model that goes all the way back to quantums can be useful (if not interpreted over-literally) but it's not necessary to do great things. Mankind advanced greatly before superstring theory, which still isn't perfected, just by induction from constantly observed regularities -- these substances make strong steel, these combination's make an explosion, air patterns work this way, so a plane can fly, even if we don't know much about how the individual molecules and quantums in the air work, and so on.

Steve: agreed. Even if we observe that prices change infrequently, it doesn't mean that prices are "sticky" in the sense required for (e.g.) Keynesian or old monetarist macro to work. I had a good argument with David Andolfatto on this a few months back, laying out my reasons for thinking prices are (probably) sticky in something like the required sense. http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/07/why-im-still-a-stickyprice-macroeconomist.html

We had a conversation about this the other day. The funny thing is that it's the macro people who spend their time worrying about price stickiness. I/O people, whose stock and trade is pricing, do not seem to think that price stickiness is worthy of study.

Steve; on the I/O people. That is funny/interesting. Here's my take. It might just be that there's nothing intrinsically interesting about price stickiness for the I/O people. Or, maybe, it's one of those fallacies of composition things. Price stickiness might be unimportant at the individual firm level, but if there are real rigidities, small nominal rigidities at the individual level might add up to big nominal rigidities at the aggregate level. Or maybe the other shocks the I/O people are interested in tend to cancel out at the aggregate level.

Here's a simple heuristic argument for sticky prices: For a small open economy, there are two indices of the value of money: the CPI level and the exchange rate. Anybody can forecast next month's CPI within (say) 1%; nobody can predict next month's exchange rate within 1%.

That doesn't prove anything, of course. There are exceptions (Zimbabwe). And if you try, you can build a flexible price macro model with the right kind of shocks and policy where it's true. But it strongly suggests the CPI is sticky. And even under fixed exchange rates, the 1 month ahead CPI level is still very forecastable, which it shouldn't be if the forecastability were just an artefact of inflation targeting.

Yes, it is certainly quite clear that the prices of goods do no behave like asset prices do. But I've never liked the idea of treating that as an assumption, rather than something we are trying to explain.

Agreed. It's an assumption we ought to *hate*. But the world won't stop while we figure out why prices seem to be sticky. So we hold our noses and just assume they are. We know we will very probably make mistakes by following this quick and dirty strategy. But in my judgment we will make much bigger mistakes by not making this assumption.

Economics has always "black boxed" tricky problems, that we can't yet solve. We black-boxed the firm, by just assuming that firms exist and maximised profits. That's a really ugly assumption for a discipline that takes pride in its methodological individualism. But we did it for decades. And we still do it, outside of Coaseian I/O. We black boxed the household too.

But don't stop "hating" this assumption. Just understand why (some of us) make it, even though we hate it too (or are too old, and have given up banging our heads against this brick wall).

I could say exactly the same thing about models which do/do not formally explain monetary exchange. Except there, many of the people who just assume monetary exchange don't even realise they are making this assumption.

And all macro models black box property rights. Why don't people just take what they want, rather than using exchange? Maybe, if we modelled property rights formally, we would get a very different equilibrium price vector. But we don't.

In re the Rowe/Williamson sticky price debate: An Interpretation:Williamson is an advocate of intelligent design: the "right prices" are designed top-down by the Walrasian auctioneer in effect. Whereas Rowe believes in the theory of evolution: the "right" prices are never really arrived at, the economy is constantly adapting to shocks and the limited information processing of real-life agents means that it takes time to do so. Sticky prices are a flip-side of Arnold Kling's recalculation thesis. Brian Loasby once wrote that in a time of uncertainty - such as we have now? - the rational decision may well be to do nothing - including not changing your price. So uncertainty, recalculation, sticky prices are all aspects of the same thing.

New classicals are impatient for those prices to adjust so in best creation science tradition he orders by fiat: Let the prices be equilibrium ones! by construction.

Peter Howitt and Robert Clower argued that prices are the only co-ordinating system in new classical macro and they were at one time attempting to build more "evolutionary" models using agent-based modeling to reflect that in the real world there are institutions (eg loan officers in banks) who have to use judgment in decision-making, they cannot rely on the "given" price.

Tricky, isn't it? The model won't be useful unless you leave a lot of things out. What do you leave out and what do you put in? Of course, it depends on the problem. If you think about the price stickiness problem, the solution that we came up with in Keynesian economics wouldn't strike you at first blush as the natural one. Firms are setting prices in nominal terms, which has something to do with the medium-of-exchange role of money. For some reason or reasons, firms aren't changing their prices continuously, and this leads to some kind of market failure. Firms coordinate on the wrong equilibrium, they get the prices wrong, or something. We correct this by having the government buy stuff? You would think that doing something to fix the price adjustment would be optimal.

Why do you start with the burden of proof being on people to justify a role for government? I thought Greenwald & Stiglitz(1986)gives us that whenever there is some asymmetric information (i.e. in life, always), there almost always exist tax interventions that are Pareto-improving. Obviously, we have no guarantee that government will pick them, but we have no guarantee the other way either. It's simply up to your prior. The best we can do is pragmatically look at the relevant local situation, ponder about the general equilibrium effects (or "unintended consequences"), and hope that we don't miss anything big.

Anyway, if we want to go back to early justifications for government you might want to start with Hobbes, T. ~Larry.

Yes, Stiglitz had the view that private information justified any number of government interventions. If you take the most general kinds of private information economies, however, and take a mechanism design approach, it's not clear what part of the solution is the private sector and what part is government. For practical purposes, for example, the private sector appears to do a fine job of supplying auto insurance (with some regulation of course), which seems to have plenty of moral hazard and adverse selection associated with it. I would say private information is neither necessary nor sufficient for government intervention to work.

Steve: I basically agree with your 12.05. Except I would put priority on monetary rather than fiscal policy, precisely because the underlying problem is monetary in nature. Sticky prices in terms of the medium of exchange mean that the real quantity of medium of exchange is "wrong".

"You would think that doing something to fix the price adjustment would be optimal."

Optimal, Possible, Practical, and Worth-the-Cost-Involved, are all different things.

It would be optimal if all voters understood the risks of global warming, and the risk-return tradeoff of finance. It would be optimal if we could completely educate all voters, but it's not possible and practical to try to 100% eradicate ignorance, so we have to consider what is the best policy in dealing with the amount of ignorance that will nonetheless exist even with the best worth-the-cost efforts to combat it.

I'm not 100% sure that my house will burn down, but I still confidently buy fire insurance and confidently advise others to do so.

Ignorance, or asymmetric information, is a big problem, and understandably in such a complicated advanced world. A large scale survey found 97% of climatologists who are active in research think that human activity is a significant contributing factor in global warming, but only 58% of the public thinks this (http://www.eurekalert.org/pub_releases/2009-01/uoia-ssa011609.php). An AP poll found that 59% of Americans would oppose any climate bill if it would cause their electricity bill to rise by even $10 a month (http://www.tnr.com/blog/jonathan-chait/76575/the-planet-isnt-cooked-yet).

You don't have to be 100% sure of something to be confident, when you have to make a decision – and doing nothing is a decision – in your decision to do something about it.

The private sector seems to do ok at auto insurance, and the public health systems of countries like australia and france seem to do pretty well on lots of metrics. Do I think the US should therefore have "socialized" medicine? Not necessarily, there's lots of historical path determinacy and such like. To be conservative in the Burkean sense is to have a strong prior on the existing arrangements (whether they involve government or not) on the basis that there are likely good reasons we ended up organizing stuff like we did. As a general point, the Coasean tradeoff is between administrative regulation and the courts, which have lots of problems of their own. I'm thinking of Shleifer's "Efficient Regulation" here.~Larry

The chicken is coordination. If you have a model where decentralized decisions lead to sub-optimal outcome (such as excessively high unemployment), there is a role for government action. This is for the simple fact that the government is big and can tax. The latter is helpful because coordination is a public good.

The IS-LM view of the world is one where the market, for whatever reason, can't coordinate on keeping employment high.